Bad Contracts Can Sometimes Make You Good Money

Companies that build big, complex projects often do so on long-term contracts. If they fail to anticipate costs or control expenses in the course of those contracts, they often pay dearly. Current stockholders may suffer whenever these companies eat losses on contracts gone bad, but one costly contract doesn't make a company a lousy investment. The following three companies are all facing major contract troubles right now, and this could provide you with a profitable buying opportunity.

An aircraft-parts maker not making much profitSpirit AeroSystems manufactures and designs critical aircraft components. Most of its work is done for major manufacturers such as Boeing, which accounts for about 84% of Spirit's sales. Though the company has plenty of business, with revenue up 13% to $1.5 billion in the latest quarter, its profitability has been less assured.

Spirit produced an operating loss of $239 million in the recent second quarter, compared to operating income of $83 million in the prior year. The large deficit resulted from pre-tax charges of approximately $448 million from five different contract programs that exceeded budgeted expectations. Disturbingly, this large write-off comes shortly after a larger $590 million in contract losses was announced in late 2012.

Given the size and frequency of such write-offs, investors have lost faith in the company's ability to make meaningful money. Spirit's reliance on future work it will do for Boeing's new 787 aircraft only makes things more uncertain. Its losses on past contracts make it harder to have much confidence in Spirit's assumption of the 787 project's profitability.

Spirit does have some positives going for it, however. It has plenty of work lined up, with a backlog of approximately $38 billion in orders. About 85% of its recent $448 million quarterly charge was pre-emptive as well, relating to future years. With all that future bad news already baked into its share price, Spirit's shares might have room to rebound if the company can get back to consistent operating profitability.

The engineering giant that buckled against a windFluor , a highly respected engineering and construction company, shows that even those at the top are not immune from contract problems. The company posted a fourth-quarter 2012 loss of $4 million, thanks to a $265 million after-tax charge related to an adverse judgement on its Greater Gabbard wind farm project. Fluor was thus unable to recoup extra costs arising from project delays and productivity issues at the $1.8 billion job.

Though this write-off was substantial, it has not seemed to hinder Fluor's current operations. In the latest quarter, the company reported earnings of $161 million, flat year over year. Revenue came in at $7.2 billion, comparable with the company's results in 2012. Increased work in the company's oil and gas division and additional assignments in the power segment thanks to utilities changing over to natural gas helped offset weaker results in government and mining businesses.

Fluor's shares have rebounded nicely from 2012's troubles and look fairly priced. Reasonable business value seems around $62 a share at a 12 times multiple of operating cash flow, slightly lower than its 2010-2011 multiple average of 13 times.

The calculation assumes expected revenue of $29 billion with an average operating cash flow of $841 million at a 2.9% cash flow margin. This compares to the company's four-year average margin of 3.2%.

An offshore-construction company's collapsing contractsMcDermott International , an engineering and construction company focused on offshore oil and gas projects, reported a terrible quarter recently. It posted a net loss of $149.4 million, compared to income of $52.7 million a year earlier, with revenue falling abut 27%. The poor showing mainly resulted from some significant project charges and a reduced workload from last year.

The company's competency at contract management can certainly be called into question. This quarter's results were decimated by a $62 million write-off on a deepwater project in Malaysia and a $38 million charge to a project in Saudi Arabia. The company's Atlantic-based operations did not escape unscathed, either, as two contract write-offs there helped crush any chance for profitability.

The Atlantic segment additionally included two projects in Brazil that contributed revenue, but no income, in the quarter. Management noted that the Brazilian projects contain such significant levels of uncertainty that they can't assume any income from these in 2013.

The good news is that the company has clearly realized its contracting problems. It is taking some significant steps to improve the bidding and execution process. First, McDermott is overhauling the leadership of its project delivery teams, bringing in people from outside the company when necessary. It is also setting up project-level incentive plans that more directly align individual compensation with project performance. The company has also increased its focus on bidding for contracts only in areas of the world where it feels like it has the best odds of making money.

Assuming McDermott can get its project management issues under control, its share price appears intriguing. Fair business value looks around $11 to $12 a share at a 16 times multiple of operating cash flow, slightly lower than its 2010-2011 average of 18 times. The estimate is predicated on expected revenue of $2.9 billion, with an average operating cash flow of $171 million at a 5.8% cash flow margin. This is discounted from the company's four-year average margin of 6.8%.

ConclusionCompanies who do business with long-term, fixed-price contracts occasionally have to report large losses from project missteps. These losses aren't necessarily an indication of how the company will perform in the future, however. Investors might want to look for firms like McDermott, which has realized its contract mistakes and is implementing solutions. By keenly watching for any sign of a successful turnaround -- an improved earnings report or increasing cash flows, for example -- an alert stock picker may find these temporarily troubled businesses a compelling investment choice.

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